Chapter 2. Cost Management
Chapter 2. Cost Management
Chapter 2. Cost Management
MANAGEMENT
• 2 . 1 An important part of project
management is the project cost
management. It covers the scope of
cost estimations and budgeting.
Moreover, cost control ensures that
the project stays with in the financial
boarders which are defined in the
budgeting process.
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Although the estimation, budgeting and
control of costs are defined as three
unaffiliated processes in theory, they are
strongly related and interacting.
S i g n i f i c a n t f o r t h e p r o j e c t c o
s t management is its concentration on
the cost generated by the performance of
the project schedule.
But in addition to this, it should also deal
with the effects of the cost management
decisions on the project deliverable in the
form of ‘life cycle costing’.
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For example, saving costs in research
and development in construction
phase could decrease the quality of
the final goods and therefore, puts
the project’s objectives at a risk.
The way the project cost
management is dealt with varies
according to
1. the different requirements of each
project. Eg. Industrial
manufacturing products, financial
sectors.
2. The ways and points of time measuring
of the project costs have to be
adapted to the project’s character.
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3. To the special needs of the
individual stakeholders.
In order to estimate the project cost
and to generate an a p p r o p r i a t e
budget, i t i s necessary to have an
overview of the different kinds of
costs that are implemented in the
nature of projects.
One can define main types of costs,
which are the direct costs( direct
materials and direct labor), the
overheads and the general &
administrative costs.
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2.2 Classification of Costs( eg a mfg project)
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The direct costs are the most
important costs in project cost
management( prime costs).
The projects cost management’s
task in cost e s t i m a t i n g i s to
e x a mi n e the different
possibilities to spend costs in
various project steps.
Input for the estimation of costs
of a single activity from the
project’s schedule are the amounts
of all resources which are required
to perform that activity. 1-6
Another document which provides
necessary information to facilitate the
creation of the cost estimate is the
Work Breakdown Structure(WBS).
WBS describes all tasks that are
included in t h e p r o j e c t ’ s p r o g r
e s s e s a n d t h e i r relationship.
A general overview about the
execution, monitoring and
controlling of the project is provided
by the project management plan.
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2.3. Processes of cost management
Many i nputs are r e q u i r e d t o
creat e a comprehensive project cost
plan.
1. The environmental factors have to be
stated( e.g marketplace conditions: available
products and services on the market and by
whom they are supplied.
2. . The c o n s i d e r a t i o n o f w e l l - k n o w
n d a t a a n d predetermined
approaches(prearranged policies in the
organizations like operation boundaries).
3. Schedule management plan(lists of
activities, duration of activities and resources
requirement).
.Such type of cost estimate is called top-down.
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2.4The earned value terms and
formulas:
It is one thing to meet a project deadline at
any cost. It is another to do it for a
reasonable cost. Project cost control is
concerned with ensuring that projects stay
within their budgets, while getting the
work done on time and at the correct quality.
One system for doing this, called earned
value analysis, was developed in the 1960s
to allow the government to decide whether
a contractor should receive a progress
payment for work done. The method is
finally coming into its own outside
government projects, and it is considered the
correct way to monitor and control almost
any project. The method is also called simply
variance analysis.
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One of the primary jobs of a project
manager is to manage trade-offs among
time, cost and performance/scope/[ex: •Can
reduce time by increasing costs; or Can reduce performance by
reducing costs]
9/5/2023
Takele Fufa, PhD
2.5The Profitability Measures (ROS,
ROI, NPV, IRR and BCR)
North South
Operating income $180,00 $40,00
0 0
After-tax operating 120,000 24,000
income
Average operating 2,000,00 200,00
assets 0 0
Average current 400,000 36,000
liabilities
Net sales 2,600,00 100,00
0 0
North South
Return on sales (ROS) 6.92% 40.00
%
Investment turnover 1.30 0.50
(ITO)
ROI (ROS x ITO) 9.0% 20.0%
ROI and New Projects Example
Suppose that Altus has a minimum required rate of return
for all investments of 10%. Each division is considering a new
project. The expected return and initial investment of each
project is shown below. If ROI is used to evaluate division
performance, will each division accept or reject the new project?
Are these decisions in line with the best interests of Altus?
North South
Project income $7,500 $2,25
0
Project $80,000 $15,00
investment 0
Project ROI 9.38% 15.00
%
North South
Operating income $180,000 $40,00
0
After-tax operating 120,000 24,000
income
Average operating 2,000,00 200,00
assets 0 0
Average current 400,000 36,000
liabilities
Net sales 2,600,00 100,00
0 0
North had an ROI less than the 10% minimum required, which
translates to a negative residual income. South’s ROI exceeded
the 10% minimum, so it had a positive RI.
RI and New Projects Example
If RI is used to evaluate division performance, will each division
accept or reject the new project? Are these decisions in line with
the best interests of Altus? The minimum required rate of return
for all investments of 10%.
North South
Project income $7,500 $2,25
0
Project $80,00 $15,00
investment 0 0
Project ROI 9.38% 15.00
%
North would reject the project because $7,500 – 10% x $80,000 < 0. If
North accepted the project, its new RI would be:
[$180,000 + $7,500] – 10% x [$2,000,000 + $80,000] = ($20,500).
South would accept the project because $2,250 – 10% x $15,000 > 0. If
South accepted the project, its new RI would be:
[$40,000 + $2,250] – 10% x [$200,000 + $15,000] = $20,750.
Each division’s decision is in line with Altus’ best interest.
7. Economic Value Added (EVA®)
• EVA® is a residual income calculation
with specific definitions of income,
investment and rate of return.
• Income is defined as “adjusted”
after-tax operating income.
• The required rate of return is defined
as the weighted average cost of capital
(WACC).
• Operating assets is defined as
“adjusted” total assets less current
liabilities.
• EVA ® ’s “ adjustments” are specific
to the organization’s structure and
goals.
EVA® Example
Altus Industries has two divisions, North and South. Given the
information below, compute the EVA® for each division.
Assume that the North Division has a WACC of 5% and that
South Division has a WACC of 18%.
North South
Operating income $180,000 $40,00
0
After-tax operating 120,000 24,000
income
Average operating 2,000,00 200,00
assets 0 0
Average current 400,000 36,000
liabilities
Net sales 2,600,00 100,00
0 0
Provide downstream
resource impact visibility.
Provide life-cycle cost
management
Influence R&D decision-making
Support downstream
strategic budgeting.
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There are also several limitations to life-cycle
cost analyses. They include:
The assumption that the
product, as known, has a
finite life-cycle.
A high cost to perform,
which may not be
appropriate for low-
cost/low-volume production.
A high sensitivity to
changing requirements.
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Life-cycle costing requires that early
estimates be made. The estimating
method selected is based on the
problem context (i.e., decisions to be
made, required accuracy, complexity of
the product, and the development
status of t h e p r o d u c t ) a n d t h e
o p e r a t i o n a l considerations (i.e.,
market introduction date, time
available for analysis, and available
resources).
The estimating methods available
can be classified as follows:
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a. Informal estimating
methods
i. Judgment based on experience:
When using the subjective method,
the estimator relies on his experience
of similar projects to give a cost
indication based largely on ‘hunch’.
Geographical and political factors as
well as the more obvious labour and
material content must be taken into
account. Such an approximate method
of estimating is o f t e n g i v e n t h e
d i s p a r a g i n g n a m e o f
‘guesstimating’.
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ii. Analogy.
When a new project is very similar to
another project recently completed, a quick
comparison can be made of the salient
features. This method is based on the costs
of a simplified schedule of major components
which were used on previous similar jobs. It
may even be possible to use the costs of a
similar sized complete project of which one
has had direct (and preferably recent)
experience. Due allowance must clearly be
made for the inevitable minor differences,
inflation and other possible cost escalations.
SWAG method
ROM method
Rule-of-thumb method
b. Formal estimating m.ethods
Detailed (from industrial
engineering standards):
Parametric(statistical):Statist
ical
database can provide
expected values which
requires parametric cost
relationships to be established.
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Life-cycle cost analysis is an integral
part of strategic planning since today’s
decision will affect tomorrow’s actions.
Yet there are common errors made
during life-cycle cost analyses.
● Loss or omission of data
● Lack of systematic structure
● Misinterpretation of data
● Wrong or misused techniques
● A concentration on insignificant facts
● Failure to assess uncertainty
● Failure to check work
● Estimating the wrong items…..END…… 1-43